Three Unlearned Lessons From the Financial Crisis

Sept. 26 (Bloomberg) -- There are three straightforward and
rather obvious lessons from the collapse of Lehman Brothers
Holdings Inc. five years ago: The financial crisis was
devastating; we haven’t ended the problems associated with “too
big to fail” financial institutions; and we must force the
biggest banks to break up -- or risk dire consequences.

The crisis had huge costs, in both economic and human
terms. Almost every official and politician understates these
costs, though fortunately Tyler Atkinson, David Luttrell and
Harvey Rosenblum of the Federal Reserve Bank of Dallas have
produced a definitive accounting.

I would begin with their measures of lost output. Their
crucial point is that this recession recovery wasn’t V-shaped,
but rather something much more protracted. Lost output -- goods
and services that we shall never see -- was at least 40 percent
of 2007 gross domestic product and probably considerably more.
Add other costs, including the human damage caused by long-term
unemployment, and the shortfall easily reaches at least one
year’s output -- say, $15 trillion in round numbers.

Any claims that the crisis wasn’t so bad, or that the
government ended up making money on bailouts, or that the banks
only received short-term liquidity loans, completely fail to
understand the way financial crises wreak havoc. The crisis had
a huge cost, even though large financial institutions (after
Lehman) were prevented from failing through generous government
support.

Hard Questions

The hard question isn’t what we would do the next time a
Lehman fails or is on the brink of failure. We would still want
to save the world from financial collapse, and there are many
creative ways for a government or a central bank to provide
support to troubled institutions.

We don’t want to reach any such point again, so the much
tougher question is: How do we prevent any financial institution
from becoming so big and so complex that its distress -- even
without outright failure and losses for creditors -- could
contribute to a panic that depresses real output and threatens
to bring the global financial system to its knees?

The Dodd-Frank Act didn’t end “too big to fail.” The
legislation was intended to reduce -- and hopefully eliminate --
the implicit and explicit government support that, post-Lehman,
could reasonably be presumed to buttress large financial
institutions.

Too big to fail will end only when regulators properly
implement the financial-reform measure. Title I of the law
authorizes the Fed to force financial companies to change their
activities -- including their scale and scope -- when it is
determined that the institutions couldn’t be resolved in an
orderly fashion through the standard bankruptcy process.

Looking at the costs, both direct and indirect, of the
Lehman collapse, it’s clear that running any of our big
leveraged financial companies through bankruptcy would cause
major economic turmoil.

Unfortunately, the Fed’s Board of Governors has been
unwilling to apply the law in a full and fair manner. Banks that
submitted inadequate living wills were simply asked to provide
new ones, without any discernible consequences. This game
probably will go on until the next major crisis.

Title II of Dodd-Frank creates a resolution mechanism known
as orderly liquidation that would be administered by the Federal
Deposit Insurance Corp. But this takes effect only if
determinations under Title I turn out to be inaccurate -- that
is, if the Fed allows a company to operate and it is later
discovered that its distress cannot be handled through
bankruptcy, at least not without catastrophic consequences.

Calling Bluffs

I support the efforts of the FDIC to design an approach to
resolution that reduces taxpayer risks and limits the disruption
to credit markets when a big financial institution gets into
trouble. (I’m on the FDIC’s Systemic Resolution Advisory
Committee, but I wasn’t involved in the design of this
mechanism.)

The FDIC procedure is designed to impose losses on
creditors of bank holding companies while protecting creditors
to operating subsidiaries. As a consequence, private lending to
a holding company should carry a premium interest rate relative
to loans to an operating subsidiary, which involves less risk.
This approach will work only if the Fed -- and, again, the Board
of Governors in particular -- requires banks to have enough
equity and long-term debt issued by the holding company to
absorb potential losses. So far, the signs from the Fed about
their thinking on this issue haven’t been encouraging.

The upshot is the simplest lesson of all: We must do more.
The largest U.S. financial institutions need to become small
enough and simple enough to fail without bringing down the
global system.

This is the only credible way to threaten the banks -- and
their executives -- with potential failure if they take on and
mismanage excessive risk. Everything else is ultimately a bluff
that will be called.

(Simon Johnson, a professor at the MIT Sloan School of
Management as well as a senior fellow at the Peterson Institute
for International Economics, is co-author of “White House
Burning: The Founding Fathers, Our National Debt, and Why It
Matters to You.”)